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Personal InvestingTom Stevenson
11 Jan 2019 03:48pm

How much cash?

Most people’s savings will have some cash, alongside other holdings of shares, funds, bonds, property and perhaps commodities like gold. But how much is the right amount?

Caption: The pros and cons of liquidity

Of course, this is a ‘how long is a piece of string’ kind of question. The right proportion of cash will vary according to your personal circumstances and appetite for risk. But there are a few considerations that apply to all of us.

There are some good reasons to hold cash in an investment portfolio. The first is the security it offers. The value of cash does not change, in nominal terms. It fluctuates against other currencies, of course, but if your outgoings are priced in sterling that does not matter. A pound will continue to be worth a pound. If capital preservation is your priority there really is no substitute.

The second good reason to hold cash is as dry powder in volatile markets. Share prices can swing far from their fundamental value as investor sentiment changes. This creates opportunities both to take profits and to pick up bargains. But an investor can only take advantage of the latter if they have some cash to hand. If the market falls sharply and you are fully invested you cannot buy new shares at attractive prices.

The third reason to hold cash has not been much in evidence over the past ten years or so. Like shares, bonds and property (but not gold), it can provide an income. This may still be hard to find in this country, where interest rates remain below 1%. In the US, however, Treasury bills are now offering a competitive yield and in due course cash will offer an acceptable yield in other countries too. Some good reasons to consider cash, then. But there are also reasons not to have cash in your portfolio. Or not too much anyway.

The most important of these is that over time cash has tended to deliver a worse return than riskier assets like bonds and shares. The difference may seem small in the short run but over an investing lifetime the shortfall can be very significant.

According to the latest edition of the Credit Suisse Investment Returns Yearbook (February 2018), one dollar invested in a representative spread of shares in 1900 would have grown to $11,141 by 2017. Even accounting for the impact of inflation, that dollar would have become more than $380. By contrast, the real inflation-adjusted value of a dollar invested in bonds over that period would have been just $10 and less than $3 if the money had been invested in a cash deposit.

Obviously, this is a far longer period than anyone will personally invest for. And clearly the last hundred years or so has been a good period to be invested in shares. But the point is clear - investors have generally been rewarded for taking risk and have paid a very high price for the apparent security of cash.

The difference in nominal and inflation-adjusted returns highlighted here shows the other main reason to be wary of holding too much cash. The income it offers has tended over extended periods of time to be less than the increase in prices. In real terms, cash has therefore lost value. This is obvious to anyone who remembers how much a loaf of bread or pint of beer cost when they were younger.

The third reason not to hold too much cash is the difficulty in actually putting it to work at the most opportune moment. The best time to invest is invariably the moment when it feels hardest to do so because the outlook is poor and the security of cash is most reassuring. You will often hear other investors boasting about how they got out of the market at the top - far less often do you hear about how they got in at the bottom.

So, there are reasons to hold cash and reasons not to. How much, therefore, makes sense at the moment?

For all the reasons above, the past year or so was a good time to have a bit more cash than usual. Markets generally were disappointing in 2018, particularly in the final quarter of the year. A higher weighting in cash would have protected your capital and provided the firepower to take advantage of today’s lower prices.

If you are in that fortunate position, then now might be the time to take advantage of relatively attractive valuations. The FTSE 100 has fallen from a high of over 7,900 in May to less than 6,750 today. In Japan, the Topix index peaked at over 1,900 in January and recently fell to little more than 1,400. Even the relatively-high-flying US market has taken a sizeable tumble in recent months. The S&P 500 index was over 2,900 in October and even after its rally after Christmas remains below 2,500.

With markets likely to remain volatile in the near future, it will pay to retain some cash. But more than around 10% of your total savings feels too conservative with markets as beaten up as they are today. If you have been erring on the side of caution, now might be the time to put some cash to work.

The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Overseas investments will be affected by movements in currency exchange rates. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.